Senate Questions Rating Agency Role in Market Turmoil

The three major rating agencies came under attack again last week when the U.S. Senate Committee on Banking, Housing and Urban Affairs held a meeting about the agencies' role in the current credit markets turmoil. Senator Christopher Dodd (D-Conn.) and Senator Richard Shelby (R-Ala.) presided over the hearings.

Aside from representatives from Moody's Investors Service, Standard & Poor's and Fitch Ratings, the Senate committee also called Securities and Exchange Commission Chairman Christopher Cox, Columbia University law school Professor John Coffee and Arturo Cifuentes, a managing director at R.W. Pressprich & Co., to testify regarding the issue.

In their testimonies, the rating agencies enumerated the various measures they are currently taking to address investor distrust and to enhance the ratings process. For instance, S&P Executive President Vickie Tillman said that S&P has focused its efforts on enhancing its ratings process, providing increased information to investors and promoting confidence in its ratings.

"The actions focus on raising transparency - providing the market with greater insight and understanding of the analytics and information supporting the ratings so investors can make better informed investment decisions - as well as Standard & Poor's rating practices and processes," Tillman said. Fitch President and CEO Stephen Joynt and Moody's Senior Managing Director Claire Robinson made similar assertions.

Despite these efforts, however, Cifuentes remained pessimistic in his outlook. "Whatever one's preferred diagnosis, a fact remains: From a ratings' point of view this has been the worst disaster in the history of the fixed-income markets," Cifuentes said in his testimony.

The rating agencies failed not once but twice, he said. The agencies failed when they "misrated" a significant number of subprime securitizations and when they did the same thing for ABS CDOs. He noted that ABS CDOs accounted for more than 90% of the U.S. CDOs downgraded in 2007.

"Consequently, at the heart of the crisis there is a painful truth: market participants do not believe in the rating agencies anymore," Cifuentes said. "One of the keys to ending this crisis is restoration of confidence in the agencies and their methods of analyses."

In his testimony, Cifuentes mentions two misconceptions about the rating agency business model: the fee issue and the agency-as-architect issue. He added that the alleged link between the rating agency fee and the banker working on deals is "weak at best," contrary to the common notion that bankers pay the rating fee, creating a conflict of interest.

In terms of the second issue, Cifuentes testified that the interaction between the bankers and the rating analysts is one of normal give-and-take and not one where the agencies provide "excessive guidance."

A solution that Cifuentes proposed regarding the fee issue was that rating fees be distributed more evenly throughout the life of the deal, instead of the rating agencies being paid a significant upfront fee and a fairly minor monitoring fee for continuing to look at deals.

Meanwhile, in his testimony, Cox said that the SEC will "issue rule proposals for public comment in the near future" regarding the role of credit rating agencies. This is why Cox was only able to outline the rulemaking areas under consideration including accountability, transparency, and competition, and not specify what will actually go into the proposed rules.

In related news, last week the Real Estate Roundtable, the Mortgage Bankers Association the Commercial Mortgage Securities Association, and the National Association of Realtors wrote Senators Dodd and Shelby regarding their concern over and opposition toward proposals to differentiate between credit ratings for structured finance products and other asset classes, such as corporate and municipal bonds.

Jan Sternin, senior vice president at the MBA, said that it is counterproductive to make changes in rating methodology "at this time frame when we are trying to restore investor confidence and liquidity in the capital markets."

She added that, "a triple-A is a triple-A is a triple-A. That's how structured finance investors came to use it before the market became more focused on municipal and corporate bonds." Sternin said that she is confident that once banks' portfolios are right-sized and these institutions are done with their write-downs, the market will be able recover. When the recovery happens, differentiating between the sectors should not be necessary. "You'll see investor confidence come back with more conservative underwriting and the real estate market remaining fundamentally sound, especially in the commercial real estate sector."